We all know that businesses need to be profitable. Yet every single day, businesses who are capable of delivering good service fail.
In this article I'll show you the basics of running a profitable service business, and how to avoid the common pitfalls.
Understanding Profit
At the heart of any capitalist system is the idea of a business generating more income than the capital invested in it, and retaining this surplus as profit. Ensuring your business is profitable must be an essential part of your strategy, tactics, and day-to-day activities. While it is not the only consideration in a business, it should infuse every management decision in the organisation, from top to bottom.
Key stakeholders should know, at any point, what the business overheads are, what their break-even point is, and what their customers are willing to pay.
But before we get into that, let's start with the key concepts and numbers.
Gross Profit Vs Net Profit
Gross Profit (GP) is usually defined as normal operating income minus direct costs, or cost of goods sold (COGS). Direct costs are the costs of the materials and labour directly required to complete the job or produce the product.
Net Profit (NP) is gross profit minus overheads. Overheads typically include such things as rent, office expenses, utilities, vehicles, insurances, and interest, which cannot be allocated directly to a specific job or product. They can also include depreciation and amortisation of assets. In simple terms, net profit is how much money the business has left over after it has received all its income and paid all its bills.
Basic Reports
A Profit and Loss Report shows profitability for a given period:
Income
Less Cost of Goods Sold:
- Raw materials
- Technician Labour
- Other direct costs, e.g. freight, equipment hire etc
= Gross Profit / Loss
Less Overhead Expenses:
- Rent
- Utilities
- Admin Staff
- Superannuation and other employment costs
- Vehicle costs
- Other overhead costs
= Net Profit / Loss
Balance Sheet
While a profit and loss report shows profitability over a given period, the Balance Sheet shows a snapshot of whether the business has retained the profit on the capital invested. This retained capital is known as owner's equity.
The basic formula of a balance sheet is Assets - Liabilities = Owner's Equity.
For example, if an entrepreneur started a business by investing $100,000 at the start of the year, on day one the balance sheet would look like this:
Assets: $100,000 (cash in the business's bank account) - Liabilities: $100,000 (the money the business owes you) = Owner's Equity: $0
After the first year, if the business had made a $25,000 net profit and the owners had not withdrawn any of that, the balance sheet would look like this:
Assets: $125,000 (money in the bank) - Liabilities: $100,000 (the money the business owes you) = Owner's Equity: $25,000
Return On Investment (ROI) = $25,000 (25%)
Drilling into Costs
Accountants and shareholders may be satisfied to view profitability on a quarterly or annual basis, but managers need to look more closely to determine the true profitability of each area of the business and inform their decisions on pricing, budgeting and benchmarks.
Break Even
Your break even - or make-break point - is the minimum gross profit required to cover overhead costs. Knowing these numbers is vital to ensure you remain in business. The best way to do this is to divide your annual overheads into smaller timeframes, such as the quarter, month, or week. For service businesses with employees on regular hours, it should be broken down to an hourly overhead cost.
For example, If your overheads are $100,000 per year, that works out to:
$8,333 per month
$1923 per week
$273 per day
$34 per hour
This would be the absolute minimum amount of gross profit the business would have to generate in order to stay in business. But realistically, it will be a lot higher than that. You're not going to be open 365 days a year, or even 52 weeks of the year. There will be holidays, sick leave, long service leave, employee entitlements, assets to replace and so on. Plus there is time lost to meetings, training, travel, stocktake, none of which are billable to the customer.
An accurate overhead cost calculation will take all of these into account, as well as any future planned expenses such as higher rent from a new premises. For a really accurate overhead cost calculation, email me via the contact form and I will walk you through one so you can set your prices and income targets with confidence. The truth can hurt. But not as much as bankruptcy!
Markup vs Margin
Profitability is commonly thought about in terms of percentages. But profit can be measured in two different ways: markup and margin. One of the most common beginner mistakes is to confuse the two.
Definition of Markup
Markup is the percentage of the cost price you add to generate your sell price. If you think about pricing by looking at your costs and adding, say, 20% to generate the sell price, you're thinking in terms of markup.
Markup = (Sell Price - Cost Price) / Cost Price
Definition of Margin
Margin is profit as a percentage of the total sell price. If you look at a project or product or business period and want to know how much of your income was retained as profit, that's margin.
Margin = (Sell Price - Cost Price) / Sell Price
Why it Matters
The downside to confusing markup and margin is that you can lose money. If you apply a percentage markup and then expect to see that same percentage as a profit margin, you will be disappointed, as you can see from the table below:
Cost | Markup | Sell | Margin |
|---|---|---|---|
$100 | 100% | $200 | 50% |
$100 | 50% | $150 | 33.33% |
$100 | 33.33% | $133.33 | 25% |
$100 | 25% | $125 | 20% |
$100 | 20% | $120 | 16.67% |
$100 | 10% | $110 | 9.09% |
Which Should You Use?
Remember, both margin and markup are derivatives of cost and sell prices; they are two different ways of looking at the same thing. But they begin from different places - markup starts with costs, and margin starts from the sell price. Whichever you are most confident about should determine the method to use.
So where should you set your price? Setting profitability percentages is an important decision that should take into account a number of factors, including the customer's willingness to pay, your overall business strategy and the amount of risk involved. But in lieu of any other factors, I recommend the following:
Markup is generally best where:
You have little information about price the customer is willing to pay or about your competitors' prices.
Your cost prices are well-known or fixed (e.g. you can only get your goods from one supplier so you cannot reduce your costs).
You need to minimise your risk (e.g. fluctuating supplier prices, projects with unforeseeable variations and risks).
Margin is best where:
You are confident about your competitors' prices and the price the customer is willing to pay.
Your costs can be reduced (e.g. through better management, supplier competition etc).
There is little risk, or the risk can be easily absorbed by the sell price.
Generally, markup is also more forward looking, and margin is more retrospective.
For this reason, projects are often quoted using a markup methodology. The quantities are estimated, the supplier's costs are obtained, and then a markup is applied, with due consideration to the customer's willingness to pay.
At completion of the project, the project manager's success is measured by comparing the actual profit margin with the initial estimate.
Profit as Value
One useful way to think about profit is the part of value chain retained by your business:
With this framework, a number of things become clear:
In order to confidently set your sell price, you must learn everything you can about both your cost price and your customer's willingness to pay. This applies to both labour and materials.
Lowering your costs and increasing your customer's willingness to pay provides more room for profitability.
If you do not add value between your supplier and your customer, willingness to pay will be low, and you will have very little room for profit.
Finding a profitable niche is about discovering and exploiting an area where you can create high perceived value (WTP) at low costs.
Profitability and Strategy
In order to retain consistently high profitability, it takes more than simply knowing your costs and customers' WTP. Truly successful businesses have a strategy to widen that gap as much as possible in a way that their competitors cannot or will not do. This is what is meant by a competitive advantage.
Bringing Costs and Pricing Together
Here's what we've covered so far:
Know your overhead costs and determine your honest break-even point. Cut any unnecessary overhead expenses.
Know your customer's willingness to pay. Make sure you are adding maximum perceived value to increase your customer's WTP, and always price below that in order to incentivise sales.
Know your competitor's costs so you can determine your positioning in the market, and look for areas you can establish or exploit a competitive advantage.
Consider pricing carefully: think about markup, margin and discounts:
Look for areas where you may be able to boost profitability while staying below the customer's WTP (hidden pockets of profit).
Fix or eliminate areas where you cannot get your costs beneath the customer's WTP.
Here's a chart which should tie it all together:
COMMON Profit PITFALLS
There are probably as many ways to lose money as there are to make it. But here are the most common pitfalls I've found (and found myself falling into).
Profit Guilt
For some people, the idea of charging more than you absolutely have to is seen as greedy, selfish, or even sinful. On face value, this is actually a reasonable position, and I can sympathise with it myself. But in reality, profit is your only guarantee of ongoing success and your only financial reward for the risk of being an entrepreneur or investor. Your business needs a surplus to ensure its stability during tough times. Fulfilling your obligations to your employees and customers depends upon having enough of a surplus to ride out the rough patches that you will inevitably encounter.
A manager or business owner who is afraid to charge enough to make a profit places their employees, their business and their reputation at risk. If there isn't even a shred of Gordon Gecko in you, you're probably not suited to the role.
High Turnover
Increased turnover can boost your ego and create a 'wealth effect', making you insensitive to costs and prone to overspend because you think you have the money to spare. But just because you've doubled your turnover, doesn't mean you're making any profit. When turnover is increasing, it is vital not to lose control of your bills.
In the immortal words of Theo Pafidis, "Turnover is vanity; profit is sanity."
COUNTING OTHER PEOPLES' MONEY
An increase in turnover can also create a temporarily bloated bank account before your bills are paid, and that includes the tax man. That's why it's essential not to use your bank account as any measure of solvency or success. Always look at your profit and loss reports and balance sheets - these will show your real financial position. Do that, and the bank account will take care of itself.
offering Discounts
Consider this scenario: You are selling a $1600 item at a 25% margin ($1200 cost). In order to close a deal or entice customers during a downturn, you decide to offer a 20% discount, dropping the price to $1200.
By dropping your prices by 20% you have actually cut your profit margin by 100%! You will make no money on this item.
Remember, all discounts come straight out of your profit margin first. Additionally, discounts provide an asymmetrical incentive. 20% is not that large a discount to a customer, but it can completely wipe you out.
There is another, positive side to this, and that is: in order to double your profitability, you do not need to double your prices. You only need to double your markup.
In the example above, if you could sell the $1600 item at $1800 without affecting your sales volume, you would increase your profitability by 50% while only increasing your prices by 12.5%. If your customers are willing to pay it and you don't increase your prices, you are throwing money away.
Optimism Bias
In our plans, things tend to go to plan. We smash out the work ahead of schedule, the customers are thrilled, we make a handsome profit. Our subordinates soak in our wisdom and manifest it in their daily actions. We are never sick.
In the real world, accidents happen. Cars break down, customers are inexplicably difficult, there is a blackout on the hottest day of the year, the client has changed their mind again, and now the project is over schedule.
People so reliably underestimate their project schedules and costs that it is now standard practise for some governments to automatically add "uplifts" or blowout allowances to the schedule and budget estimates they receive from contractors.
Your overhead cost calculation, estimates, and pricing decisions should always allow for everyday accidents, and price the risk accordingly. Expect the unexpected - and charge for it.
Race to the Bottom
It's a huge contract. You know the your nearest competitor has come in lower than you. But the client says he likes you and wants to give it to you. Sure, it's going to be tight - maybe too tight - but a low margin on a project that size is still a lot of money. You start to think about all the ways the project could go right - maybe we'll work extra hours on this one just to get it done on schedule. Plus it will impress them, and we'll surely win more work!
Motivated reasoning like this is a quick way to find yourself worked to death for no profit at all. Large businesses often dangle these carrots in front of their competing contractors in the hope that one of them will be unable to resist the allure of big money. Don't fall for it. Know your costs, price your risks, and don't let anyone - especially yourself - talk yourself out of them.
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